Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

III. Measuring Transaction Costs with Post-Trade Analysis

have been observed if the trade had not taken place. In this case, the difference between this price and the trade price could be pinned entirely on the trade. Different transaction cost indicators are used for different benchmarks. The indicators can be based on pre-trade, intraday or post-trade benchmarks. Furthermore, in each of these three categories, an additional distinction can be made between absolute indicators and time-related indicators. Absolute indicators are easier to compute because they do not require consideration of time stamping. In other words, these indicators do not take into account the exact time at which the trade is executed. By contrast, time-related indicators are dependent on the exact time at which the trade is completed. They rely on a benchmark price that is computed around or at the execution time. These indicators use benchmark prices prevailing on the market before the execution of the trade. The most frequent are based on the following benchmark prices, depending on whether they consider the accurate time of execution or not. Absolute indicators: •  T-1 Close: previous night's closing price •  T Open: opening price of the day Time-related indicators: •  Ask: last ask price before execution •  Bid: last bid price before execution •  Last: last trade price before execution • Midpoint bid-ask: last bid-ask average before execution (1) Indicators built upon pre-trade benchmarks

As Harris (2003) notes, it is hard to manage effectively what you cannot accurately measure. Proper measurement of transaction costs is thus crucial for quality decision-making, since it permits assessments of portfolio profitability and final performance. More broadly, accurate transaction cost measures are also useful for building and testing transaction cost estimation models. In this section, we discuss the two currently used fundamental approaches to measuring transaction costs. These approaches are the benchmark comparison and the implementation shortfall. We then identify common pitfalls to look out for when measuring costs and offer a critical review of the most popular indicators. The section concludes with a discussion of complications brought about by MiFID. 1. Benchmark Comparison This method involves comparing the monetary value difference between the executed position and the position evaluated at a benchmark price. For a given transaction, the monetary value per share is given by the signed difference between the average price obtained for the trade and the benchmark price. A positive value indicates an execution that is less favourable than the benchmark price, while a negative value indicates execution more favourable than the benchmark. Negative costs, in other words, are savings. The choice of benchmark is primordial here. For one, the benchmark price should be easy to obtain or compute. For another, it should be ideal, in the sense that it should enable assessment of the price that would

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An EDHEC Risk and Asset Management Research Centre Publication

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